Why is Yardstick competition useful in setting hospital reimbursement?

HEALTH ECONOMICS TOPICS
>Introduction
A very large portion of health budget are spent to hospital. Therefore, since last two decades, many country try to find out the appropriate mechanism to reimbursement hospital. Since the number of hospitals are limited and have at least some monopoly power, it seems market competition is not work for hospital. With market power, hospital tend to provide services at a certain level where they can get maximum profit. As a result of monopoly, welfare lost tend to occur. To overcome this problem (inefficiency) Yardstick competition are introduced. Yardstick competition try to replicate perfect competition under monopoly situation. How Yardstick competition work and the way the system try to reduce the cost will explain below. The paper start by explaining very brieftly about monopoly.

Monopoly
Most hospitals face down slope demand curve. It mean that they have some degree of monopoly power. Therefore, hospital try to decrease the quantity of health care services in order to maximize the profit. In the case, the quantites are reduces to Qo with the price at Po. Where if hospital has acted as competitive firms, they should expanded their production at the point of R, where Marginal Cost equal to Demand with the price of Co. From social perspective, under monopoly market, hospitals create welfare loss as much as represented by MAR.



Yardstick Competition
Yardstic competition, try to replicate perfect competition under monopoly market. This method assumes that all hospital are able to invest in cost-reducing technology in effort of reducing Average Cost. A hospital is reimbursed at the average of treatment cost of all other hospital in the market. Payer observes the average of marginal cost of all paticipant of market regularly, then introduce a new average. This procedure continue until the average of marginal costs no longer falls. At this point, price become equal to MC. Theoritically, this result is same as the result of perfect competition.

Reaction of Hospital to Yardstic Competition
The average and marginal treatment cost are constant and initially treatment costs are Co. Hospitals are reimbursed as much as Co. Each hospital has to provide of teatment at which MC is equal to market price. In order to make a profit, the hospital can invest in cost-reducing technology, incurring fixed costs, to lower marginal treatment cost of production to C* and the hospital finds a new AC curve as given by the curve AFC+C*. The firms can invest for further cost reduction until MC of investement exceed MR gained by the investment. The new output occur is equal to demand price, which is at B, then optimal provision becomes Q1 and the price fall to P*. Then if the marginal costs of the firm is still above C*, the firm will lose the amount represented by vertikal line area. To compase government provides a lump-sum subsidy to that hospital. However, if the hospital succeed in lowering marginal cost to C1, the hospital gain incremental pofit represented by horizontal line area.

In conclusion
Under retrospective payment system, hospital have no incentive to reduce cost and to increase efficiency. In contrast, under yardstick competition, hospitals are pushed to be cost concious and cost containment by improving efficiecy. Yardstick competition lead to optimal equilibrium which is know as Nash equilibrium. A situation where each firm does the best that it can, given the decision of others. It is equlibrium because once choice are made no firm has any motive to change its action. However, this system work if there is no collusion